QUESTION NO.
O1(A)
The time path of unemployment in relation to inflation can be explained through the
lens of the Phillips Curve, which is represented by the equation you've provided. Let's
break down the scenarios:
(i) Inflation is always zero:
If actual inflation (π) is always zero and expected inflation (Eπ) is also zero, then the
term -a(π-Eπ) in your equation would be zero because (π-Eπ)=0 his means that there
would be no impact from inflation on the unemployment rate, so the unemployment
rate “U” would equal the natural rate of unemployment "U*”.
In economic terms, with no inflation, the natural rate of unemployment is considered
to be the equilibrium state of the labor market where the number of workers firms
want to hire equals the number of workers willing to work at the current wage rate.
Over time, as long as inflation remains zero, the unemployment rate should stay at
this natural rate, barring any other external shocks or policy changes.
(ii) Inflation is a constant five percent:
When actual inflation (π) is a constant five percent and this rate is fully anticipated
(meaning expected inflation Eπ is also five percent), then once again, the term −
−a(π−Eπ) would be zero because π=Eπ. The anticipation of inflation would lead to
adjustments in wages and contracts, which would negate the effect of inflation on
unemployment
Therefore, in this scenario, the unemployment rate u would also equal the natural rate
of unemployment u∗, because the effects of anticipated inflation are neutralized in the
long run. Workers and firms adjust their expectations and contracts to account for the
anticipated inflation, so it does not cause unemployment to deviate from its natural
rate.
In both cases, the long-term time path of unemployment would be at the natural rate
u∗, assuming other factors remain constant and there are no other shifts in the
economy. However, if inflation is not anticipated (for example, if people expect less
than five percent), then in the short run, unemployment could temporarily deviate
from the natural rate until expectations adjust.
QUESTION NO. O1(B)
(i) What is the expected inflation?
When inflation is random and uniformly distributed between 0 and 10 percent, the
expected inflation Eπ can be calculated as the average of the minimum and maximum
values of the distribution. In a uniform distribution, this is simply the midpoint
between the two extremes.
So, Eπ would be:
Eπ= (0%+10%)/2= 5%
(ii) What does the observed Philips curve look like?
The observed Phillips Curve in the case of random inflation between 0 and 10 percent
would not be a stable or consistent curve as it would be under predictable inflation
scenarios. Instead, it would fluctuate because the inflation rate is not constant, and the
actual inflation could be any value between 0 and 10 percent at any point in time.
Since unemployment is affected by unexpected inflation (the difference between
actual inflation π and expected inflation Eπ), and in this case, the expected inflation is
always 5 percent, any actual inflation rate other than 5 percent would create
unexpected inflation. When actual inflation is lower than expected, unemployment
would be higher than the natural rate u∗ because nominal wages are set higher than
they would be if actual inflation were anticipated. Conversely, when actual inflation is
higher than expected, unemployment would be lower than u∗, as real wages are lower
than anticipated, leading to higher employment in the short run.
This means the observed Phillips Curve would scatter around the natural rate of
unemployment u∗ with a cloud of points showing higher unemployment when
inflation is below 5 percent and lower unemployment when inflation is above 5
percent. This scattering reflects the short-term trade-offs between inflation and
unemployment when inflation is unpredictable. However, over time, as people adjust
their expectations, the long-run Phillips Curve would be vertical at the natural rate of
unemployment, implying no long-term trade-off between inflation and
unemployment. (I HAVE ALSO ATTACHED THE GRAPH)
QUESTION NO. O1(C)
Here is a graph that simulates the observed Phillips Curve given random inflation
between 0 and 10 percent:
The x-axis represents the inflation rate.
The y-axis represents the unemployment rate.
Each blue dot represents a possible combination of inflation and unemployment
rates at a point in time.
The red horizontal line marks the natural rate of unemployment, which is
assumed to be 5% for this illustration.
The scatter of blue dots shows the variability in unemployment rates due to the
random inflation rates. If inflation is unexpectedly high (above 5%), the
unemployment rate tends to be below the natural rate (and vice versa). In the long run,
as expectations adjust, the points would cluster around the natural rate of
unemployment, reflecting the vertical long-run Phillips Curve.
QUESTION NO. O1(D)
The menu of inflation-unemployment combinations available to policymakers in an
economy with a uniformly distributed inflation rate depends on their understanding of
the Phillips Curve and the expectations mechanism.
Actual Menu Available:
Given that inflation is uniformly distributed between 5 and 15 percent, the expected
value of inflation, E(π), is 10 percent. If policymakers understand the Phillips Curve
and the expectations mechanism correctly, they would know that:
In the short run, they might exploit the trade-off between inflation and
unemployment. For instance, accepting a higher inflation rate could potentially
lead to a lower unemployment rate than the natural rate, until expectations adjust.
In the long run, there is no trade-off, as expectations adjust to the actual inflation
rate. The economy would settle at the natural rate of unemployment regardless of
the inflation rate. Any attempt to reduce unemployment below the natural rate
with higher inflation would only lead to ever-accelerating inflation without
improving unemployment in the long term.
Menu Policymakers Might Think They Have:
If policymakers are operating under the misconception that they can permanently
reduce unemployment below the natural rate through monetary policy, they might
believe they have a wider menu of options. They could think that by choosing a point
on the short-run Phillips Curve, they can achieve and maintain lower unemployment
by accepting higher inflation.
However, this belief fails to consider that people will eventually adjust their
expectations of inflation, which in turn will shift the short-run Phillips Curve upward,
leading to higher inflation without the benefit of lower unemployment. This is the
concept of the long-run vertical Phillips Curve, where inflation has no effect on
unemployment.
In summary, the actual menu offers a fixed point in the long run: the natural rate of
unemployment with whatever inflation ends up being. The perceived menu might
suggest a range of combinations, but this is illusory because it overlooks the
adjustments in expectations that render these combinations unsustainable in the long
run.
QUESTION NO. O2A
The optimal discretionary policy for the inflation rate, when policymakers are aiming
to maximize social welfare (V) while considering the public's inflation expectations,
is derived from the social welfare function and the output equation provided:
V=yt −(α/2)* π2t
yt =yˉ +β(πt −πte)
We need to substitute the output equation into the social welfare function to express V
only in terms of πt and πe t and then differentiate V with respect to πt to find the
optimal inflation rate set by the policymakers.
First, substituting the output equation into the social welfare function:
V=( yˉ +β(πt −πte) −(α/2)* π2t
Now we simplify:
V=yˉ +βπt − β πte −(α/2)* π2t
To find the optimal πt we take the first derivative of V with respect to πt and set it
equal to zero:
dV/d πt = β- πt
Setting this equal to zero to solve for πt :
0=β−απt
απt =β
πt =α/β
This is the optimal inflation rate under discretionary policy, without considering the
time-inconsistency problem or the reputation effects. It is derived from the
perspective of the policymakers who have not yet taken into account the public's
expectations forming adaptively in response to their policy. This solution assumes that
the public's expected inflation rate πet is given and does not adapt to the policymakers'
inflation rate choice. However, in reality, the public will adjust its expectations, which
can influence the actual optimal policy.
Given that rational private agents understand the central bank's objective function and
the Phillips curve constraint, they will anticipate that the central bank will choose the
optimal level of inflation that was previously calculated:
πet =β/ α
The agents will then set their expected inflation rate πet equal to this optimal inflation
rate:
πet=β/ α
Substituting this into the output equation:
yt =yˉ +β(πt −πet )
yt =yˉ +β (β/α−β/α)
yt =yˉ
The output (yt) equals the natural level of output (yˉ) because the actual inflation rate
chosen by the policymakers equals the expected inflation rate, resulting in no surprise
inflation to stimulate output above the natural level.
Now, substituting πt and yt into the policymakers' objective function:
V=yˉ −α/2 (β/α)2
V=yˉ −α/2 (β2/α2)
V=yˉ −β2/2α
This value of V represents the policymakers' objective function given the rational
expectations of the private agents. Here, the output is at its natural level, and the
welfare loss is only due to the cost of inflation, which is at the level chosen by the
policymakers (πt=β/ α). The economy is at a point where the inflation rate is positive
and the output is at its natural level, so the welfare loss is minimized given the
constraint of the Phillips curve.
QUESTION NO. O2(B)
If the Federal Reserve (Fed) announces that it will follow a zero-inflation policy, and
if the public believes that the Fed will commit to this policy, then the expected
inflation rate πet would be zero.
In this case, the expected inflation rate πte is:
πet=0
Given that the Fed is committed to a zero-inflation policy, the actual inflation
rate πt would also be:
πt =0
Now let's determine the output (yt) under these conditions. Substituting the values into
the output equation:
yt =yˉ +β(πt −πet )
yt =yˉ +β(0-0)
yt =yˉ
So the output is at its natural level yˉ when both actual and expected inflation are
zero.
Finally, we'll calculate the value of the policymakers' objective function (V) with zero
inflation:
V=yˉ −α/2 (πt)2
V=yˉ −α/2 (0)2
V=yˉ
In this scenario, with zero inflation, the value of the objective function is at its
maximum because there is no welfare loss due to inflation πt. The output is at its
natural level, and there are no costs associated with inflation. Therefore, the
policymakers' objective function has the highest value, which equals the natural level
of output yˉ, indicating the best possible welfare outcome under this policy
commitment.
QUESTION NO. O2 (C)
This scenario describes the classic time-inconsistency problem. The Federal Reserve
may announce a zero-inflation policy to set expectations, but once those expectations
are set, the Fed has an incentive to deviate from that policy to temporarily boost
output. If the Fed reneges on its announcement and sets the inflation rate to the
optimal discretionary rate from part (a), which is πt=β/α, then we need to calculate the
output yt and the value of the policymakers' objective function V again, under the
assumption that the public initially expected zero inflation.
Output (yt)
Given the public's expectation of zero inflation, the output equation would be:
yt=yˉ +β(πt −πet )
yt =yˉ +β(β/ α - 0)
yt =yˉ + β2/ α
The output would temporarily increase beyond the natural level of output due to the
unexpected inflation.
Value of the Policymakers' Objective Function (V)
Substituting the calculated output and the optimal discretionary inflation rate back
into the objective function, we get:
V=yˉ +β2/ α - α/2 *(β/ α)2
V=yˉ +β2/ α - β2/2α
V=yˉ +β2/2α
Comparing the objective function values:
In part (a), the value of V was yˉ- β2/2α when private agents correctly anticipated
inflation.
In part (b), the value of V was yˉ when the Fed committed to zero inflation and
the public believed this commitment.
In part (c), the value of V is yˉ +β2/2α, which reflects the temporary gain from
surprising the public with a higher inflation rate than expected.
The value of the policymakers' objective function in part (c) is higher than in both
parts (a) and (b) because it includes the temporary gain from the surprise inflation,
which increases output beyond the natural level. This higher output temporarily
boosts social welfare, according to the policymakers' objective function. However,
this is not sustainable in the long run, as expectations will adjust, potentially leading
to higher inflation without the benefit of lower unemployment, and could damage the
credibility of the central bank, leading to higher inflation expectations in the future.
QUESTION NO. O2 (D)
To overcome the time-inconsistency problem, Barro and Gordon suggested
appointing a conservative central banker who places a higher weight on inflation
stabilization than the general public does. This means that the parameter α , which
represents the cost of inflation in the central banker's objective function, is higher for
this conservative central banker than it is for society. In this case, if we denote αc as
the central banker's inflation aversion parameter and it is significantly larger than
society's α , the central banker's objective function would heavily penalize inflation,
thereby aligning the bank's incentives with the announced policy.
Let's denote the conservative central banker's objective function as:
Vc =yt−αc/2 π2t
The conservative central banker aims to maximize this function, subject to the output
equation:
yt =yˉ +β(πt −πet )
Given that αc is large, when we solve for the optimal discretionary policy, the term
αc β would approach zero because αc is much larger than β. Thus, the optimal
discretionary policy for the conservative central banker would be to set πt to zero:
πt = β/αc ≈ 0
By appointing a conservative central banker who values low inflation significantly,
the incentive to cheat by creating surprise inflation is removed, as the cost of inflation
in the banker's objective function is too high. This aligns the central bank's policy
with the zero-inflation policy that was announced, making it credible and sustainable.
In this case, with πt = 0, the output yt would again be at the natural level yˉand the
value of the objective function Vc would also be maximized, equal to yˉsince there is
no welfare loss due to inflation.
Thus, appointing a conservative central banker who places a high penalty on inflation
can serve as a commitment mechanism to overcome the time-inconsistency problem
and sustain a credible zero-inflation policy.